Creative Industrial: The Next Wave of Building Investment

We’ve come to end a long period of consolidation in the warehouse and distribution sector. Particularly over the past ten years, a handful of national owners have rolled-up a vast network of separately owned warehouses into an industrial building behemoth across the best locations. It’s a feat worthy of acknowledgement but consolidation marks a turning point. The buccaneering ethos of deal-making has been permanently replaced by a staid, institutional mindset. There is a final hurrah for Private Investors and that is Creative Industrial.

Creative Industrial is in its infancy and is not yet recognized as a product type. There is a void of institutional funding that allows room for new capital. Creative tenants, big and small, generally have better than average credit. Creative tenants will make expensive improvements by building studios and installing equipment. Downtown Los Angeles and Bushwick/East Williamsburg in New York are two examples where obsolete buildings are being turned into Class A Investments. While still the preserve of mostly individual investors, Creative Industrial will comprise the next multi-billion dollar REIT.

Creative Industrial goes way beyond the Arts Districts, it’s the “creative vernacular”, typified by light and space, that will be the next wave of industrial building improvements throughout the region. Light is created by cutting in windows and skylights. Space is an aesthetic that supports operations, creativity, and more pragmatically, increases income by making unusable space, rentable. Stemming from temporary improvements, made to buildings to obtain short term income, many landlords and investors have caught on that creative redevelopments can boost rents.

The creative vernacular applies to the vast number of buildings beyond the special districts and into the general heartland of industrial buildings. Beyond the buzz, there are many buildings that have been left to deteriorate and require improvement to attract the next generation of tenants. Creative Industrial is a value-add strategy for buying right, improving, and increasing rents.

Rates of return reflect general monetary conditions and speculative risk in an otherwise stable product type and location. Acquisition Cap Rates are 5% on a reasonably stabilized basis and increase with risk. An empty building with extensive development yields above 10%. Historical nominal appreciation for industrial real estate in Los Angeles is above 10% annualized. Modest leverage provides mid-to-high teen annual returns for stable product over the long run and substantially higher if there is development risk. $5,000,000 to $15,000,000 is the sweet spot which is still below institutional levels but large enough to earn profits.

Creative Industrial buildings are good deals for the following reasons. There is scant know-how to find, reposition and execute, especially in cases where each building needs separate and precise improvements. There is a reasonable profit spread between pre-and-post redevelopment that investors can skillfully capture. Creative districts are exploding in activity with new development reaching billions of dollars of mostly residential construction. Investors receive current yield, long term growth, and stability in excess of what can be found in public markets.

The most common buyers are wealthy individuals by themselves or in partnership. More would invest but access to market data and investments is limited. Searching for deals is greatly improved by having an apparatus to capture current, “on the ground” information. As data science merges with more conventional real estate practice, many creative buildings will undergo rigid analytics for investment potential just like for distribution buildings. Because of the sheer number of possible buildings, every major investor is developing a strong data operation to sort through best deals. For instance, one technique is to use location enabled video and 360 photography to augment traditional real estate data in a scale efficient manner.

The biggest challenge is finding the properties either by personal relationships or some sort of active and deliberate process. So far, for Creative Industrial, there are few large investment organizations with a dedicated acquisitions team as you find in the Distribution sector. Most buildings in the creative space have been too small for large investors to seek and manage. However, because of substantial relative returns, experience in buying and managing thousands of homes with iBuyer algorithms will be applied to Creative Industrial.

Warehouse and distribution remain the dominant industrial building type. However, with most warehouses in only a few hands, the potential to earn ownership income from industrial real estate has shifted to Creative. We are thankful to be in the right location and with the right tools to be at the start of a booming avenue of industrial building investment.

The New Industrial Real Estate Business

If you are buying, selling or leasing, today’s industrial real estate business has permanently shifted. It has become an investor led market that was originally established for Occupiers. Investment fundamentals supersede many traditional occupancy concerns. Industrial markets became financialized because of strong and increasing money flows from institutional funds, REITs and private investors. In the New Industrial Real Estate Business, profits accrue fastest to those who treat their buildings like an investment product. The primary market driver is improving income through rental increases, operations, and tenancies. The wave of financialization is affecting most local industrial markets in the best metros and is visible building-by-building. Technical sophistication and specialized platforms are the new means of operating in today’s industrial building business.

Not long ago, Corporates and Owner-Users owned most of the industrial property and the industry revolved around Occupier decisions and corporate strategy.  When investors played a role, it was in support of Occupiers. While institutions, particularly insurance companies, were always significant investors, the Great Recession was an inflection point. Institutional Investors expanded their investments in industrial property to find yield (and income) when most interest rates were at zero. Ten years later, Institutional Investors want even more industrial and they have noticeably increased hiring and investment allocations.  Dynamically, it’s not Occupiers making periodic relocations, but the volume of institutional investment that is moving markets.

Financialization creates generous rewards to find and create income.  We see many large and small platforms infused with intelligence and designed for profit. Substantial investment is being made in data collection, imagery, new tech products, and custom programs.  While there is still a premium for human experience, many processes are being organized for machine intelligence and prediction. As an example, Big Data, Search, Platforms, Geolocation, Visualization, and Content Marketing are now commonly used to find deals and operate property. More than methodology, financialization and enabling technologies are transforming fundamental concepts like value, agency and risk.

Value is determined by income and not how well the building fits a business. With income as the primary measurement, pricing fluctuates based on market and financial variables. Scarcity, rent surges, volatile interest rates, hot money, and other timely events will affect real time value.  Conventional market data, like appraisals or comps, sets limits, but it does not capture the fluctuations within that band that can vary between 10% and 20%. Errors in human behavior during a deal may also add considerable variance. Value investors measure real time signals and capture part of movement in the purchase price. Pricing falls in a range, but value is created by reading signals and applying skill.

Agency is another change.  Traditionally, Agents provide access to markets and develop strategies for positioning, marketing, representation, and advocacy. Agents also bridge common language and cultural barriers between ethnic groups and the space markets. However, big changes are coming to the Agency business, due to financialization and online platforms. When buildings become investment products and can be informally rated, they can be directly traded on platforms amongst experienced buyers, with or without agents.  Space with certain homogenous characteristics are also traded with less friction. On platforms, transaction fees are reduced because conventional broker duties of fiduciary and agency are replaced by electronic trust, certification and experience. Commodification of building investments and rentable space is allowing platforms to grow and requiring agents to adapt.

Investors view risk differently than owner-occupiers.  For example, portfolio investors can take more risk  on any single property than individual owners with their wealth in only a few assets. More importantly, investors invest in tools and personal relationships to reduce risk and increase income. Digital operations, for example, yield analytics, no matter how basic, that measure performance and improve decisions. You can move the odds in your favor with better intelligence and technology. Risk measurement, enabled by advanced analytics, is a new and determining factor in local industrial markets.

Financialization creates an environment with continuous market signals. Signals are seen, measured, and evaluated.  In many ways it’s unfair for individual owners because they lack the same tools or access to information as big investors. But individual owners can reverse the tables with shrewd calculations and turn the tight market to their advantage. In cases of leasing or selling, operating on a carefully designed platform, with market data and transaction capability, will put the odds back in your favor. As industrial markets move from local to national, capabilities extend from the personal to the digital.

Financial fire power and technical sophistication is putting local industrial property in the hands of national and global investors. It’s an unstoppable wave that creates many positive effects through plentiful liquidity and dynamic markets. Competition from investors has made owning your own industrial buildings more difficult, but the ability to invest and operate with less risk has greatly improved. In the New Industrial Real Estate Business, capital and technology are the primary forces moving the markets. While Big Investors and financialization create the momentum, good tools are available for anyone to adapt, participate and succeed.

Industrial Buildings: From Private Hands to Institutional Buyers

One of the longest running trends in industrial real estate is the shift of ownership from private hands to institutions. Traditionally, insurance companies, pension funds, and real estate investment trusts (REITs) would purchase new developments and industrial parks after they had been leased and stabilized. It served as both a guaranteed exit for entrepreneurial developers as well as the way investors would acquire property to match long term obligations.

The long-term trend of institutionalization metastasized after the Great Recession when the industry faced low interest rates and the search for yield. Suddenly, institutions grew a fondness for all things industrial. To make sure there were enough assets to buy, they began opening their standards to older and smaller properties by expanding the definition of “Institutional Grade.” Today—at least in major markets—a 25 year old, 50,000 square foot building is now a highly sought-after product type by institutional investors. Continued low-interest rates and below trends economic growth signal that the returns from real estate are still relatively attractive and that institutional activity will continue.

The significance of this trend has become evident to many SIORs. Owners and users—once the dominant buyers of older industrial buildings—have been shunted to the sidelines as they can no longer compete on pricing, terms, condition, and availability. The pathway to wealth by owning and occupying your own building is a vanishing commodity for many business owners.

For SIORs, the trend to institutionalization is a commission bonanza. During the early years of my career, large-scale institutional investors steered clear of older, inner city properties, instead focusing on larger, modern distribution buildings with major credits. Asset sales of this type would normally be brokered by the capital markets teams of major brokerages, or directly amongst the developer/investor nexus. In other words, brokers like me—independent, geographically focused, with an owner/user clientele—were locked out of the big institutional deals. Now, institutional investors are 30 percent of my business—and growing.

Evidence of this shift can be seen at the SIOR Greater Los Angeles Chapter meetings. What were once almost completely dominated by SIOR brokers, meetings are now 50 percent attended by the leading REITS, advisors, funds and private equity investors in the industry. Most have significantly boosted their acquisition teams from the abundance of the investment dollars flowing into industrial. The most lucrative part are the owner/user buildings—those still in private hands—that have become the acquisition targets of big investors.

We are at peak momentum for the shift from private ownership to institutions. This trend, however, will not last once all the assets have been transferred. It mirrors the corporate sell-off of industrial plants in the mid-1980s to early-1990s. Once all of the plants were shut down and sold, it permanently reduced the influence corporations and real estate directors had on industrial real estate markets. Today, once those industrial properties leave private hands, there’s no going back to the owner/user market of old.

It’s important to note that many of the largest buyers are starting to use machine learning, artificial intelligence, and “Big Data” in their searches for properties. These are methods that have been taught by their peers in the stock and bond industry. The results on practitioners are fee compression and a reduction of human interface. Many of the largest buyers are using data and analytics to go direct—willing to pay brokers if they are part of the transaction—but at the same time entitled by their models to find the deals wherever they can.

Strong money flows keep the business churning. Success goes to those who can locate or create the deals, but once those buildings are sold, we will need to search for new opportunities in the industrial real estate universe. Enjoy it while you can.

As seen on SIOR Pulse